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In Rewards Cards’ Terms, How Much Really Is 5% Back?

If you have a good credit score, you’ve probably received a credit card offer in the last few months advertising, in huge print, 5% cash back — like the Chase Freedom or Discover More.

It’s a compelling offer. (I mean, just look at those flip flops.) If 1% cash back is good, 5% must be five times as good.

As far as I can tell, the card companies must be pushing these offers for one of two reasons:

1. They’ve decided that they love their customers and want to give them extra money, no strings attached.

Sorry, I can’t type the second reason, because I’m laughing too hard. Mary Ann Campbell of IndexCreditCards.com, sums it up: “It’s a strategy that is in favor of the card companies.”

What’s the catch?

The idea of tying a generous rewards program to a credit card isn’t revolutionary. Issuers have been offering more than the standard 1% for years, and many responsible credit card users have been paying off their balances in full each month and literally getting free lunch in the form of hundreds of dollars in cash back each year. But lately, it seems, getting that free lunch more often than not requires you to suit up, gladiator-style, and step into an arena. Your opponent: a bank that spends its days trying to figure out how to extract as much of your money as possible.

Let’s look at one popular example: the Chase Freedom card, which offers 5% cash back in certain categories. Right now, from January through March, those categories are grocery stores and drugstores. You get 1% cash back in other categories, like a typical reward card.

So that’s 4% bonus cash back (5% minus the 1% you would already get). Sounds great—except there’s a cap. You only get the cash back on up to $1,500 in purchases, for a maximum of $20 per month in bonus rewards. Furthermore, if you shop for groceries at a warehouse club or superstore, those purchases are ineligible (though they still earn 1%).

Oh, it gets richer (not literally). In order to qualify for the 5% cash back, you have to visit the Chase web site and sign up before you spend. Chase wins whether you sign up or not: if you forget to sign up (and you have to do this every quarter), they don’t have to pay. If you do sign up, your brain lights up with reward fever. Time to start spending!

“We are very transparent about the details of this program,” a Chase spokeswoman said in an email, pointing out that Chase’s reward cap is displayed prominently on the web site.

A spokeswoman for Discover, meanwhile, pointed out that the company “has awarded more than $8 billion in cashback bonus since the program began” — in 1986.

How to turn 5% into zero

Rewards cards, as you probably know, tend to have higher APRs than regular (non-reward) credit cards. Right now, the cash-back cards charge an average 16.47% APR, according to Bankrate.com, while all variable-rate credit cards charge an average 14.34%. (Low-rate cards average 10.70%.)

Chase Freedom’s APR ranges from 13% to 23%, depending on your credit. On a $2,500 balance, even at the best-case 13% APR, interest on the balance will completely wipe out the maximum bonus cash-back you could earn ($60) within three months.

“It only works for people if you pay it off monthly, but human nature sets in and not everybody does that,” says Campbell, who carries the Chase Freedom card (and pays it off monthly).

We now have data suggesting that for some people, simply having access to a reward card encourages overspending. At the Federal Reserve Bank of Chicago, economists Sumit Agarwal, Sujit Chakravorti, and Anna Lunn looked at a dataset from a large, anonymous national bank that sent 1% cash back reward cards to a random subset of their existing, non-reward credit card customers. The customers, unsurprisingly, reacted to this by spending more on the reward card.

Most of this new spending came from using other cards less. After all, if you get a new reward card, why would you continue using your old, non-reward card? (One reason is that non-reward cards charge a lower average APR, but customers generally ignore the APR.)

But some of the spending and debt—especially among customers who didn’t use their card at all before getting the cash-back offer—couldn’t be explained by replacing other cards. “We find that 11% of those guys start using the card as a result of the cash back,” says Chakravorti. “And we also find that their credit bureau balances go up.”

It’s kind of reassuring that only 11% of a subgroup went into debt because they got a new card, until you realize that a large proportion of everybody else was already in debt. That is, they didn’t lose this round of the game because they’d already gotten slaughtered in a previous round.

The Chase spokeswoman said she hadn’t read the study but that the Chase Freedom card is designed to reward customers for the types of purchases they already make.

You’re the best around

In a classic 1981 survey, 98% of Americans identified themselves as above-average drivers. Scientists call it the Lake Wobegon Effect, after the town where every kid was above average. Most people believe their relationships are above average. Professors, students, doctors, stock traders—all believe in droves that they’re among the best at what they do. (And, of course, my kid is smarter than your honor student.)

Similarly, nobody signs up for a credit card believing they’re going to sink into debt and throw away money on finance charges. But more than half of credit card holders carry a balance for at least part of a given year, according to data from the Federal Reserve. As painful as it is to even consider the notion, if you sign up for a reward card believing your behavior is going to be above average, there’s a good chance you’re fooling yourself.

This is not to say that all credit card debt is bad (there are certainly worse kinds of debt, though not many) or that it’s invariably the result of misbehavior. But part of what goes on in our brains when we try to wrap them around reward programs is that we value the points very highly when we’re trying to earn them, but we treat the same points as play money when we spend them, explains Kit Yarrow, a consumer psychologist at Golden Gate University. “So they overvalue it when it’s coming in and undervalue it when it’s going out,” says Yarrow. “That equation adds up to financial disaster.”

I asked Yarrow what a reward card user can do to protect themselves from their own bad behavior. “You can’t make purchases factoring in the 1% savings you’ll get with getting rewards money back,” she says. “You just can’t.”

Yarrow carries a Schwab cash back card (which is no longer available, but Fidelity offers a similar one) that pays the rewards into her brokerage account. “It’s maybe better if you look at the end of the year and see what you’ve gotten,” she says. “It may make it easier to resist that allure.”

We’ll make you pay

Campbell suggests another strategy. “What I recommend people do if they’re using a reward card is to contact their issuer and have their full payments drafted from their checking account automatically,” she says. It won’t protect you from overspending, but it means no missed payments, no finance charges, and no forfeited reward points.

And I’ll add one more: You don’t have to use a credit card to be a grownup. What’s the most you can lose by not participating in a rewards program? About 1%. What’s the most you can lose if you do participate?